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7 Risks of Investing in Bonds for Beginners

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Bonds are generally considered to be safe investment options. They offer income in the form of annual or semi-annual coupon payments, which are calculated by applying the fixed coupon rate on the face value of the bond. Some bonds, like those issued by governments and creditworthy corporate entities, are considered to be safer than others that are issued by companies with low credit ratings. But to fully understand the risk profile of a bond, you need to delve a little deeper. In this article, you can find out the finer details of the types of risk in bonds and how you can manage them.

Types of Risks in Bond Investing

The exact nature of risks associated with investing in bonds depends primarily on the type of bond you purchase. Broadly, these are the types of risks associated with bonds that you need to be prepared for. 

Interest Rate Risk

This is the risk of the bond’s price falling as the interest rates in the market rise. If the interest rates are on an upward trajectory, newly issued bonds will offer more attractive coupon payments than the bonds you hold, which carry older and lower interest rates. As a result, the prices of the old bonds become less attractive for investors, who will prefer to buy the new bonds with higher interest rates. 

To Manage the Interest Rate Risk:

You can consider investing in short-term bonds instead of long-term bonds, provided they align with your goals.

Inflation Risk

Inflation is the decrease in purchasing power over time. This is why inflation risk is also known as purchasing power risk. It is the risk of the bond yield not being enough to combat the effect of inflation. So, over time, the inflation-adjusted returns from bonds will reduce even if the coupon rate remains the same. This type of bond risk is common in most bonds that offer fixed or floating interest rates that do not account for inflation.

To Manage the Inflation Risk:

You can invest in inflation-indexed bonds, which are benchmarked against inflation-based indices.

Credit Risk

One of the most common types of risks associated with investing in bonds, the credit risk is the possibility of the issuer not being able to meet their financial obligations towards the investor. In other words, they may not be able to make the coupon payments or repay the par value of the bond. This bond risk is negligible in government bonds but is higher in corporate bonds — particularly if the instrument is issued by companies with low credit ratings. 

To Manage the Credit Risk:

You can invest in government bonds that are backed by a sovereign guarantee or in highly rated corporate bonds. 

Liquidity Risk

This type of bond risk occurs when you are unable to sell the bonds you hold due to a lack of buyers in the market. This is common in narrow markets with low trading volumes and high bid-ask spreads. If the liquidity risk is too great, you may have to hold the bond till maturity. This could be unfavourable if you need the funds urgently to meet an emergency financial requirement. 

To Manage the Liquidity Risk:

Ensure that you do not invest funds you need over the short term in bonds with a long-term maturity period. 

Call Risk

This is a risk associated with bonds that carry a call option. If the interest rates in the market decline, the companies that issued the bonds may find bank loan rates more favourable than the coupon rates they need to pay investors. So, they may refinance their debts and call back the bonds. As an investor, you will then have to redirect the sale proceeds to a different asset, often at lower interest rates. 

To Manage the Call Risk:

You can diversify your portfolio to include both callable and non-callable bonds or choose bonds with high call premiums. 

Rating Risk

Corporate bonds are evaluated and rated by credit rating agencies based on the company’s ability to repay its debts. A company that is creditworthy today may lose its credit standing tomorrow. This, in turn, could result in a downgrade of its credit score. Consequently, the bonds it issues will also be considered poorly rated in terms of credit. This will affect the price of the bonds. 

To Manage the Rating Risk:

You can monitor the company’s performance and keep track of its news to know on time if it loses its creditworthiness. 

Systematic Risk

This type of bond risk is also known as market risk. It refers to the possibility of the entire market or market segment declining and performing poorly. As an investor, you have little to no control over market risks. This is because it is linked to macroscopic factors like geopolitical events, changes in the economy and the like. On account of systematic risk, no matter how good your bond is, it may still be negatively affected. 

To Manage the Systematic Risk:

You can diversify your portfolio to reduce the effect of systematic risks to a certain extent. 

Conclusion

Before you start investing in these debt securities, you need to account for the above-mentioned types of risk in bonds. By factoring them into your trading or investment plan, you can maintain a favourable risk-reward ratio and ensure that your capital is not eroded due to unforeseen risks. That said, not all risks involved in bond investment can be eliminated completely. Some can only be managed. The trick is to manage them smartly.

Understanding the types of risk in bonds is crucial for any investor looking to navigate the bond market effectively. By being aware of these types of risk in bonds, you can make more informed decisions and better protect your investments.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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Frequently Asked Questions

Which type of bonds is better?

Answer Field

Corporate bonds generally offer a higher coupon rate than government bonds. However, the former is exposed to a greater degree of default risk. The bond company may face bankruptcy or insolvency, leading to a capital loss. Government bonds typically have no such risks attached due to their ability to raise funds through taxes or other means to pay off investors.

What is the biggest risk in bonds?

Answer Field

The biggest risk for bonds is typically considered to be interest rate risk, also known as market risk or price risk. Interest rate risk refers to the potential for the value of a bond to fluctuate in response to changes in prevailing interest rates in the market.

Which type of bond is the safest or risk free?

Answer Field

Government bonds are amongst the safest investment options available for investment. While no investment is entirely free of any risk, the security offered by a government bond is very high. There is technically no default risk involved with a government bond due to the ability of governments to raise taxes or issue more bonds. Government bonds are however still susceptible to reinvestment and inflation risk.

Are bonds riskier than stocks?

Answer Field

Bonds tend to be less volatile and risky than stocks, and when held to maturity they offer stable and consistent returns.

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